Extending Tax Cuts Could Have Huge Debt Impact

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As Washington debates what to do about the massive tax cuts enacted in 2001 and 2003 under President George W. Bush, which expire at the end of the year, the arguments boil down to some narrow terms: The White House and most Democrats want to keep the cuts for all but the wealthiest Americans, while Republicans say that all the cuts should be extended, because small business and others can’t afford tax hikes in this weak economy.

But a new economic analysis from the Congressional Budget Office underscores how tax cuts can go from being stimulative to very negative in a short period of time. From a deficit perspective, debating only the top-level cuts overlooks the long-term economic health of the country, while no one is looking at paying for the cost to the government of prolonging the cuts.

“[The cuts], if they’re going to be deficit-financed, are going to eventually hurt the economy.”

“We don’t need to phase [the cuts] out right away, but if they’re going to be deficit-financed then they’re going to eventually hurt the economy, and in the not-too-distant future,” said Robert Bixby, executive director of the anti-deficit Concord Coalition. “That part of it is not getting enough attention, because all the Democrats are perfectly happy to have some of the tax cuts expire. If what you’re worried about is the deficit impact on the economy, that’s almost as big a hit as letting all of the tax cuts remain in place.”

The dilemma arises because the Bush-era cuts were enacted — with the support of most Republicans — with expiration dates in order to mask their potential long-term cost. Lower tax rates on income, capital gains and dividends as well a per-child tax credit were set to expire at the end of 2010. So no action now means a de facto tax increase.

Huge Numbers ProjectedLast week, CBO projected a fiscal year 2010 deficit of $1.34 trillion, second-largest since World War II (with last year’s being the largest). It also projected deficits totaling more than $6 trillion over the next decade. These are huge numbers, even though they track closely with earlier reports. But CBO’s predictions are based on current law — meaning that they assume that the tax cuts expire on schedule. Extending all the Bush cuts through 2020 would add another $2.7 trillion to the debt.

The administration says that its proposal to allow the cuts to expire only for those making more than $250,000 a year would save up to $700 billion in the coming decade. But from a deficit point of view, some Republicans point out that it would allow the cost to grow at nearly the same pace as extending all of the cuts.

Following the administration plan, along with other likely changes to current law, such as limiting the Alternative Minimum Tax and blocking cuts in Medicare payments to doctors, would have a short-term stimulus effect, CBO said. These measures would boost economic growth by an additional 0.6 to 1.7 percent over the next year, and unemployment would drop by as much as an additional 0.8 percent by the end of 2011. But the increase in interest payments on the resulting debt would soon restrict growth to a lower level than if no laws are changed.

“Unemployment would be lower next year, but also, over time, that extra borrowing — and it's a good deal of extra borrowing — would have negative consequences for the economy,” said CBO director Douglas Elmendorf last week.

The Worst Option?One option under consideration as the midterm elections loom is to extend the cuts for just a few years, until the economy recovers. But Elmendorf pointed out that an earlier CBO study found that tax cuts were among the worst options for cutting unemployment and boosting growth.

“They were at the bottom of the scale relative to the other things that we looked at because a significant amount of money goes to people with fairly high incomes,” he said. “And if those people receive a temporary tax cut, they're not likely to spend a very large share of that, in our judgment, this year or next year.” That’s especially true if the recipients think the cut will be disappearing soon after. Just extending the cuts for the wealthy for one year would add $36 billion to the deficit, according to Congress’ Joint Committee on Taxation.

Bixby of the Concord Coalition said that, while unrealistic, allowing all the cuts to lapse would put the government remarkably close to deficits at sustainable levels in the coming years. He proposes extending the cuts but phasing them out or finding a way to pay for them over the next five years.

Congress has not wanted to connect the deficit argument to the tax cut debate. Democrats, eager to re-establish their middle-class bona fides, want to extend the cuts for most Americans. When they enacted a pay-as-you-go law earlier this year, they gave themselves an exemption for extending these cuts.

Republicans believe the deficit is a spending problem, not one of taxation. Top Senate Republicans Mitch McConnell of Kentucky and Jon Kyl of Arizona say that the cost of extending these expiring tax cuts should never need to be offset elsewhere in the budget. Sen. Chuck Grassley of Iowa, the top Republican on the Senate Finance Committee, says deficit concerns are misplaced because tax-relief money belongs to individuals, not government.

Senate Budget Committee Chairman Kent Conrad, D-N.D., said in a statement that CBO’s report confirms the dire fiscal situation. “We need to do everything we can to ensure the economic recovery stays on track. This has to be our highest priority,” he said. “At the same time, to address our long-term budget challenges, we must start now to enact deficit reduction policies that will kick in after the economy has more fully recovered.” But he did not mention the tax cuts.

Even in the unlikely event that the cuts do lapse, Elmendorf warned that achieving economic stability would not be easy. “Putting the nation on a sustainable fiscal course will require policy makers to restrain the growth and spending substantially, to raise revenues significantly above their average percentage of GDP during the past 40 years or adopt some combination of those approaches,” he said.